Breach of trust: how Australian banks went bad

It did not take long for the first banker appearing in this week’s sensational royal commission hearings to crumple.

Under sustained questioning from senior counsel assisting Michael Hodge, QC, about what exactly he had apologised “unreservedly” for in a prior written witness statement, AMP’s head of advice, Anthony “Jack” Regan, pleaded for mercy.

“I will have to take that on notice,” an ashen-faced Regan told his inquisitor.

“That’s not really how it works,” reprimanded Hodge. “Is the answer you just don’t know?”

“Yes, I’m uncertain,” Regan replied.

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But the floodgates would soon open.

Over two days of questioning, Regan would go on to confess to no fewer than 20 separate occasions on which AMP misled the corporate regulator over charging “fees for no service” to clients of its financial advice business.

Spotlight on financial planners

In its three short weeks of public hearings, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, headed by former High Court judge Kenneth Hayne, has uncovered an impressive rap sheet of misconduct – including bribery, fraud and outright lying - by Australia’s banking behemoths.

AMP's Anthony "Jack" Regan leaves the royal commission.Credit:AAP

This week, the spotlight was turned on the quality of financial advice provided by the nation’s 25,000 financial planners. More than 2 million Australians pay a combined $4.6 billion a year for financial advice – with half that revenue going to bank-owned financial advice businesses.

Less radical reform options include greater accountability and transparency, and better standards and licensing of advisers.

The role of the corporate watchdog, the Australian Securities and Investments Commission, has also come into question; it has been labelled “asleep at the wheel” by some.

The royal commission is bringing to light failures in Australia’s banking system as never before. The public want answers to two questions: First, how did things get so bad in Australia's once trusted banking industry? And secondly, how can it be fixed?

What is a bank?

For centuries, the business of banking was a relatively simple affair.

Banks accepted deposits from people who wanted a safe place to store their money. Banks used that as a base to lend money to people they assessed could eventually repay the money safely.

Bankers made their money by charging the borrower an interest rate slightly above what they had to pay to depositors.

It was not until the early 2000s that Australian banks decided to enter the wealth management and financial advice business in a big way. Then head of the Commonwealth Bank David Murray - who would go on to head the Abbott government’s financial services inquiry - led the charge, acquiring former mutual company Colonial First State. A wave of takeovers ensued as banks took over life insurance companies and wealth managers: Westpac swallowed BT and NAB ate MLC.

For the first time, banks were not only manufacturing financial products – like loans, superannuation and other investments – but also employing networks of financial advisers, often under different names, who purported to provide independent advice to clients about which products to buy.

“They like to look like they don’t actually own the planners - they’ve got all these different names,” observes Brett Le Mesurier, a senior banking and insurance analyst at stockbroking firm Shaw and Partners.

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This problem of “vertical integration” has seen a disproportionate amount of client funds invested in the banks who own the financial planners from which original advice was sought.

This week former competition tsar Fels declared the conflicts of interest unmanageable and called for the structural separation of traditional banking from wealth management.

“I think they should get out of the business altogether,” says Le Mesurier. “I don’t think it fits with banking. Banking is really just deposit-taking and making loans ... This whole industry of providing advice to people about how best to use their money is something banks have never done.”

Le Mesurier says the experiment with bank-owned financial planners has failed not just customers but shareholders.

“The reason David Murray did it was because he was convinced that there was a burgeoning wealth management industry which was high-growth and low capital intensity. He would have seen going into wealth management as a high-growth, higher return on equity move that would make his business more valuable.”

“None of that happened,” says Le Mesurier, who describes the experiment as an “enormous distraction” for the industry.

“It has been increasingly problematic as margins have started to fall in the industry post-GFC - that was really the catalyst as users of the products started to look at fees in the industry and what value are you really getting for those?”

Almost two decades on, Le Mesurier says the banks are already looking at offloading these businesses. “I think they’d be pleased to see the end of it and get rid of all the compliance cost and risks associated with it, not to mention the reputational damage that’s infected their banking business.”

Nick Sherry was the minister for corporate law in the Rudd government during the global financial crisis when a Townsville-based company, Storm Financial, collapsed, incurring losses of $3 billion and destroying the retirement nest eggs of thousands of Australians who had been encouraged to borrow against their homes to buy shares.

An adviser is there in the best interests of the client, not there to flog a product.

Former minister for corporate law Nick Sherry

That inquiry led to a raft of reforms known as the “Future of Financial Advice” (FOFA), which banned commissions in the sector and introduced a “best interests” test for advice.

Sherry says it’s clear in hindsight that those reforms did not go far enough and, crucially, that a “sales flogging culture” survived.

“The industry never really understood that an adviser is not a salesman. An adviser is there in the best interests of the client, not there to flog a product. And they have continued to confuse the two.”

Sherry also supports structural separation, an idea he says was “howled down” by the sector when it was considered a decade ago.

David Murray remains convinced separation is a "red herring".Credit:Janie Barrett

Times have changed, though. Amid margin squeeze, banks are already eyeing spinning off their wealth managers.

Martin North, the principal adviser at Digital Finance Analytics, which provides research to financial services companies including banks, says there is a clear cultural clash between banks and wealth management. “Bankers never understood wealth management,” says North, who also supports separation. “You have to separate advice from the product sell.”

But there remains at least one staunch opponent to such an idea. David Murray himself remains convinced separation is a “red herring”, saying problems in the industry are not confined to the bank-owned advisers. “The question is, across the whole industry are people well served by the advice that’s provided or not?”

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Murray wants more stringent licensing, better product design and harsher penalties for advisers: “The issue is with the way financial advice works rather than those vertically integrated structures.”

Murray points out that the royal commission process is simply exposing the most egregious cases of misconduct – many of which are already known to regulators.

“It’s at a point where all of the bad stuff is coming out because that’s their job. We haven’t heard the counter-submissions [from banks] in their entirety.”

But it is this week's revelations about misconduct at AMP that have really sent shockwaves through the industry, politics and the public in general.

Most major banks are guilty of the same original sin AMP engaged in, namely charging financial advice clients “fees for no service” in cases where they acquired the “orphaned” clients from retiring advisers.

But the real rot at AMP set in when, having discovered the problem, the company set about obfuscating and misleading the regulator about it. This included redrafting “independent” legal advice from Clayton Utz 25 times, including scrubbing out Meller’s name on one draft before reinstating it.

The original behaviour – knowingly overcharging – raises problems of civil law and consumer redress. It is the second behaviour – lying to the regulator - that raises the prospect of criminal charges, according to Ian Ramsay, professor of corporate law at Melbourne University.

Under section 1308(2) of the Corporations Act, it is a criminal offence for any person to “make or authorise” a statement to ASIC which they know to be “false or misleading”. Under the current penalty regime, such people can be punished by up to five years' jail and $42,000. The new penalties increase this to 10 years' jail and nearly $1 million, but they are not retrospective.

Instead of waiting for the royal commission to make its final findings next year, Ramsay says it is time for the corporate regulator to act now.

“There’s no need for ASIC to wait until 2019. If a major financial institution has acknowledged that it has misled or lied on an ongoing basis to the regulator, ASIC needs to conduct its own investigations in relation to that, then if it feels there is a case refer it to the Commonwealth Director of Public Prosecutions, which forms its own independent view as to whether there is a case and if it does then action can be commenced.”

ASIC released a statement this week saying an investigation underway and would not comment further.

‘Asleep at the wheel’

Criticism is mounting of the corporate regulator for its role in letting the misconduct go unpunished so far.

“ASIC has clearly been asleep at the wheel and really is not up to the job,” concludes North.

“Where have they been? What have they been doing?” asks Le Mesurier.

ASIC’s deputy chairman, Peter Kell, gave evidence to the commission this week, including outlining in his witness statement how “the financial advice industry has historically been plagued by the prejudicial impact of conflicts of interest”.

While banks paid lip service to being “customer focused”, “doing what’s right” and “acting with integrity”, “the reality of their conduct does not always reflect that professional ethos”, Kell wrote.

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However, ASIC’s focus has not been on getting harsher penalties, but seeking greater powers to identify bad behaviour. “The current regulatory framework places undue emphasis on investigation and punishment after the event, and gives ASIC too few tools to address problems as they emerge or before major losses are suffered," wrote Kell.

But many argue that ASIC itself is the problem. Ramsay says the regulator has relied too heavily on simply banning individual advisers, or entering into “enforceable undertakings” with the banks rather that initiating criminal proceedings.

As far back as 2006, when AMP was found to be funnelling clients into its own superannuation products, ASIC slapped it on the wrist with an enforceable undertaking rather than taking it to court.

According to Ramsay’s analysis, criminal proceedings brought by ASIC are disproportionately against small business people, not large financial institutions or their executives.

“At the end of the day, the strongest enforcement message is to do something more than just banning people.”

Consumer groups have been calling for tougher penalties for poor advice and conducting “shadow shopping” exercises for more than three decades.

Choice’s CEO Alan Kirkland says it’s clear financial institutions have been “deliberately flouting” the FOFA reforms. “We should not forget how aggressively the big institutions fought the FOFA reforms. As recently as 2014, they were arguing for the FOFA reforms to be wound back, so they could pay bank tellers bonuses for pushing products onto customers.

“It is hard to imagine any other industry where major players have actively defied the law, with explicit endorsement from senior management.”

Kirkland says bank boss pay should be less tied to financial performance.

“It is clear that remuneration is the problem here - because banning sales commissions was never going to work while ever executives right up the line of management were being rewarded for pushing products that generated profit regardless of whether they were good for consumers."

Kirkland stresses that problems with financial advice are rife in the non-bank financial advice sector too: “One upside of having financial planning firms owned by the banks has been that they have been forced to step in and provide compensation where poor advice has resulted in losses for consumers. It's different at the small end of town.”

Kirkland wants a compensation scheme of last resort, funded by industry, where a small firm is unable to pay claims.

In a submission to the Commission, Dr George Gilligan from the Melbourne Law School says there needs to be greater emphasis on individual licensing of financial advisers - only one in three have a university degree - rather than relying on large networks to assess employees.

“Individual licensing is a must in my view if there is going to be meaningful change in the sector,” Dr Gilligan says.

According to North: “If there is any variable remuneration element that is somehow linked to the product, then you have a conflict."

To be continued ...

The royal commission’s public hearings on financial advice continue next week. The government has confirmed that if the commission requests additional time beyond its September deadline for an initial report, it will be granted.

North says this is a moment of reckoning for Australia’s banking sector, which has been hopelessly distracted from its core business.

“I think it’s time that we have some honest truths about what needs to be done. There has been a generation of fudging by the banking sector. There is a fundamental philosophical question of what are banks for? It’s not just to inflate the economy and increase credit growth.